Money-market funds

A boom amid the bust

Can the success of money funds last?

THE credit crisis has produced many losers and a few winners. Among money-market mutual funds, which invest in short-term debt and other instruments, it is the other way round. Some funds that exposed themselves to mortgage-linked exotica, albeit indirectly, have had to be bailed out by their managers. But many of the rest have done nicely as worried investors flocked to them, seeking safety.

Long an unexciting province within asset management, money funds have played a big role in the crunch. They bought much of the short-term debt that propped up structured finance. It was their sudden withdrawal that caused the market in asset-backed commercial paper (ABCP) to seize up. And banks' liquidity problems are largely the result of money funds' recent reluctance to hold their debt.

If this makes them villains, then crime pays. Money funds have been taking market share from banks for years: big banks were less interested in competing for deposits during the securitisation boom, since they were selling on their loans. The crisis only accelerated this shift, since money funds were seen as one of few havens. In America, the biggest market, their assets have increased by 39% over the past year, to a record $3.5 trillion, even as returns have fallen (see chart).

This growth has been fuelled primarily by institutional money: businesses, pension funds and local governments. By the end of 2007, money funds held a record 31% of corporate America's short-term assets, a share that is thought to have continued rising this year.

Why are companies flocking to outsource their cash management? In the boom, all that mattered to them was yield, and they did not need help finding it. Now they crave liquidity and sanctity of principal—a welcome rediscovery that short-term holdings should “bore you into a good night's sleep”, as Reserve Management's Bruce Bent, creator of the first money fund in 1970, puts it. Money funds, with robust credit departments that do not simply rely on ratings, are better placed than corporate treasurers to provide this.

There is also some back-covering at work. After over-exposing themselves to structured-investment vehicles and auction-rate securities, treasurers want to be able to blame someone else if things go wrong again. Moreover, money funds offer some built-in protection. In this crisis, as in past ones, they have shown they will do all they can to avoid “breaking the buck” (allowing their net asset value to fall below par). More than a dozen managers have stepped in to shore up funds, at a cost of more than $1 billion.

Money funds have also benefited from a withering of the competition. Ultra-short bond funds and enhanced-cash funds, which touted themselves as cash alternatives but invested in spicier debt than true money funds are allowed to, have fallen by the wayside. Peter Crane of Money Fund Intelligence, a newsletter, puts their combined assets at $70 billion, down from over $600 billion before the crisis. Meanwhile, the market for auction-rate securities is a shadow of what it was.

In some ways, money funds created a virtuous circle for themselves. As they fled structured vehicles and the like, others who had gobbled up such debt also took fright—and stuffed their money in funds instead. An unusually large share went to government debt: JPMorgan Chase's Treasury-bill fund swelled from $7 billion to $37 billion, for instance. It has lost some of that to “prime” money funds, which buy corporate debt, over the past month as investors regained some appetite for risk. But funds remain choosy about which banks they will finance. The same goes for the ABCP market, which remains one-third below its size last August.

Will money funds be able to hold on to the huge inflows? Mr Crane expects America's to continue registering double-digit annual asset growth. On the other hand, the funds tend to suffer when short-term interest rates rise, or when turmoil subsides. In a recent report, Jan Loeys, an economist at JPMorgan, predicted a bleak future for the funds in which the banks that have become so dependent on them fight back. As the lend-and-hold model of banking regains ground, he argues, so banks' interest in cutting out those interposed between them and their retail customers will grow. Already they are jostling for deposits with new-found vigour.